A rout in emerging-market assets has sparked concerns that the turbulence could spread from distant corners of the world to the U.S. and elsewhere, fueling a cycle of accelerating risk aversion.
A sharp selloff in Brazilian stocks and its currency late last week fed into a wider retreat that hit emerging-market assets from Mexico to South Africa and rattled Italy’s weakened bond market. Many currencies of developing countries are near multiyear lows, despite a boost from strong commodity prices and solid global growth, while investor allocations to emerging-market-focused bond funds are at their lowest level of the year, according to the Institute of International Finance.
The spasms highlight the effects that a stronger dollar and higher U.S. bond yields can have as they amplify the problems of vulnerable countries, threatening assets that investors recently considered to be comparatively safe. The list of repercussions includes everything from increased pressure on economies in Argentina and Turkey, which gorged on cheap debt when interest rates stood near record lows, to the rise of Italy’s populist and euroskeptic government, analysts said.
So far, few believe the weakness in riskier markets threatens the nine-year-long U.S. stock advance, but the recent market moves have bolstered the case for caution. More turbulence could be in store next week, when the European Central Bank and the Federal Reserve hold their monetary policy meetings. Many expect the Fed to raise interest rates, which would increase pressure on emerging markets and test the ability of some countries to repay dollar-denominated debt.
“Rising global real interest rates are the number one predictor of financial problems in vulnerable economies,” said Kenneth Rogoff, a professor at Harvard University and the former chief economist of the International Monetary Fund. “The risks are greater than people realize.”
Dollar strength is a danger for some countries because it weakens their currencies and makes it more difficult to pay back dollar-denominated debt. Higher U.S. rates dim the allure of foreign assets, especially in emerging markets, where investors often take on greater risk in exchange for higher yields and returns.
More than $10 billion has flowed out of mutual and exchange-traded funds that invest in emerging-markets debt and equity in the past six weeks, according to Bank of America Merrill Lynch. The outflow of money has sparked some declines in assets that rewarded investors with rich yields and big upside moves in recent years: stock markets in Brazil, Indonesia and Turkey have notched double-digit drops since mid-February, along with many emerging-market currencies.
That weakness is concerning to some, who see it as evidence that the world has slipped out of a brief period in which all economies were accelerating in unison.
“The world confused a lucky confluence of growth factors with a self-feeding synchronized pickup,” said Mohamed El-Erian, chief economic adviser at Allianz. “What’s becoming more evident today is that with the exception of the U.S., where policy is driving growth, the other factors are proving to be less durable.”
Mr. El-Erian said he is keeping a close eye on countries with a lot of government debt, as well as corporate debt, such as Turkey. Companies that borrow heavily in dollars but generate most of their revenues in local currencies, such as some in Latin American countries, are also a worry, he said.
The potential for diminished investment in these countries comes amid soaring levels of emerging-market government and corporate debt. A record $1.6 trillion of debt issued by governments, financial firms, and other companies in all currencies matures this year and $1.7 trillion matures next year, according to the Institute of International Finance. That debt, concentrated in China, South Korea, India, and other countries, will either need to be paid down or refinanced.
Developed countries that suffer from weaker growth, high leverage or an unpopular government are also vulnerable to rising rates and a stronger dollar, Mr. Rogoff said. Political jitters sent Italy’s bonds on their worst one-day slide since 1989 last month, although they have stabilized since then. Countries at the eurozone’s periphery, such as Portugal and Greece, could also experience “big problems” if global rates continue rising, he said.
For now, many believe markets will be able to weather the recent turmoil. The World Bank estimates the global economy will grow 3.1% this year, unchanged from its forecast in January and matching the pace of growth seen in 2017, itself the strongest year since 2011. While recent turbulence has hurt countries with large debt loads, other emerging markets have reduced debt and built up reserves in recent years, analysts said.
Harry Gakidis, a portfolio manager at Acadian Asset Management, said he sees recent volatility less as the start of a crisis and more as part of a sporadic selloff that happens from time to time.
“This is what you are getting compensated for,” he said.
Rising U.S. bond yields, however, may be wearing away at that sentiment. With two-year Treasury yields at 2.5%, the assets of potentially vulnerable countries become much less attractive, said Edward Al-Hussainy, currency strategist at Columbia Threadneedle Investments.
“Is the return high enough to compensate you for the risks? Clearly the answer across the board is ‘no,’” he said. - WSJ
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